Stewart Free, a partner and the NSW trustee at insolvency firm Jirsch Sutherland, revealed that his firm has seen a substantial spike in the number of insolvency cases involving director loans, and that many business owners may not be aware of the risks and ramifications associated with them.
“Used wisely, director loans can be useful. However, there are some circumstances where they present a major risk. One particular circumstance is during a liquidation,” Mr Free said.
“Many business owners use debit loan accounts to mitigate tax or improve cash flow during tough times, but the issue is that if the company gets into strife, the owner can get caught out because they are responsible for the debt. I’m seeing a lot more people become bankrupt as a result of this.”
He told My Business that his firm typically manages between 400 and 500 bankruptcies at any given point — with over 100 cases under his direct control, and he estimated that, historically, between 10 and 20 per cent had involved director loans.
“We’re [now] seeing on average 20 to 30 per cent have got loans back to companies, which either might be in liquidation or are still active,” Mr Free said.
“They have been there in the past, it’s just that there just seems to be more and more of it, as people are using it as effective[ly a] tax minimisation strategy, but get caught in the back-end unfortunately.”
Asked why this issue may be flaring now, Mr Free said that he believed it is “a combination of factors”.
“I think people are more aware that this strategy — which is a legal strategy — is there and you can use it, it is valid. But there are implications at the back-end.
“And people are also under cash flow pressures in business, with discretionary spend down, consumer confidence [down] and wage increases almost non-existent... it’s all creating almost a perfect storm.”
Mr Free also warned that it is small, family businesses which are most likely to be suffering from the fallout of director loans.
Are director’s loans directly causing insolvencies?
The insolvency specialist said that rather than being the direct cause of business insolvencies, director loans are increasingly becoming part of the factors contributing to these difficulties.
“But more and more, it’s becoming a bigger factor,” he said.
“It’s that old adage that business owners look at bank balances, but bank balance is not profitability. So they look at the bank balance, take some money, that goes against Division 7A loan; if work turns down, they can scale back.
“But if there are any creditors left unpaid and they come after them, and all of a sudden it’s got this big Division 7A loan, which a liquidator treats just like any other asset of the company, it’s almost like a cash-at-bank type of thing, so it’s due and payable.”
Should business owners simply avoid director’s loans altogether?
Asked whether, given these risks, he would advocate against the use of director’s loans, Mr Free said emphatically that, no, he wouldn’t, but rather he urges business owners to be fully aware of the implications for drawing down business funds under a director’s loan, to minimise the risk of being caught out with a personal bill owing to creditors of the business should it fail.
“Just go in with your eyes wide open about it,” he said.
“Often, they use the company bank account for groceries and school fees and all that sort of stuff, and it all goes to a Division 7A loan.”
The very fact that his firm is seeing more cases of director’s loans involved in liquidations and personal bankruptcies is suggestive of a lack of awareness as to the risks associated with director’s loans.
“Not knowing what the potential downside of it is,” he said.
‘Look at the figures’
According to Mr Free, business owners should refrain from viewing their tax returns as simply an act of compliance, but take in and use the data that it provides to understand the workings of their business.
“Actually look at the figures — look at the risk profile in there,” he said.
“If there is a shareholder’s loan, what is the strategy that the directors are going to implement to get that down if things are not looking crash-hot.”
He also advised that anyone with outstanding loans “do whatever they can to ensure those loans are repaid, over a short to medium time frame”.
“Because if you’re concerned about the Tax Office and concerned about creditors chasing you, but you think you’re going to be able to hide behind what’s already a diminishing corporate shield, the Division 7A just punches straight through it, and gives creditors via a bankruptcy trustee access to your personal assets. So, it’s almost like you’re operating like a sole trader.”
Mr Free’s comments come amid separate figures revealing a concerning increase in the number of business insolvencies and payment defaults.